The world according to QARP, or “quality at a reasonable price” investing
The world according to QARP, or “quality at a reasonable price” investing
We follow a QARP approach to investing and are often asked, “What exactly does this entail?” This is an understandable and important question, particularly in a world that places disproportionate emphasis on classifying investors by the blunt style definitions of “value” and “growth”. (Please see the end of this article for a glossary of terms).
At its core, QARP, or “quality at a reasonable price”, is investing in well-managed businesses that exhibit superior returns, generate strong cash flow and are available at attractive valuations. Which metrics one uses to gauge returns, and the potential to create economic value, very much depends on the particular industry under consideration, and there are many nuances.
However, a QARP investment approach can pay dividends, as investors in financial and commodity businesses discovered, quite literally, when Covid-19 exposed weaknesses. It was no coincidence the higher returning businesses (miners and insurers) maintained dividends, while lower returning ones cut them (oil companies and banks). (see: How finding the quality within value was crucial in 2020).
All of these businesses broadly befit a value style, but some transpired to be “value traps” for the much greater part of 2020 - although appearing to be good value, they transpired to be cheap for good reason. As QARP investors, we think in terms of economic value, which a business can create by delivering growth with superior returns.
It is for this reason that we feel bluntly distinguishing between growth and value is somewhat arbitrary and calls for a different approach.
Superior ways to gauge potential superior returns
Contrary to what many in the market currently appear to believe, growth metrics such as earnings per share (EPS) growth are not true arbiters of value creation. This is because they can be artificially boosted by methods such as merger and acquisition (M&A) activity or excessive capital expenditure.
It’s very possible for the wrong type of growth to destroy economic value.
What defines a well-managed business to us is a management team that only seeks to deploy capital when they can invest at rates of return above the cost of that capital. In the absence of such opportunities, we would expect excess capital to be returned to shareholders.
For companies exhibiting superior returns on capital employed (RoCE), we seek to understand what makes these returns durable. We like businesses which display at least one of the following barriers to entry: reputable brands, market share leadership, intellectual property, network effects, structural cost advantages and an installed product base, to name a few.
This ensures that the business is not easily replicable by competition and as a result, the “moat” – a term used to describe a company’s presently unassailable competitive advantages – around their franchise is protected for longer than the market tends to value it for.
The turmoil of 2020 provided great opportunities for long term stockpickers to buy quality companies at great prices – if they knew where to look. QARP helps investors to sort the fundamentally good and fundamentally poor companies.
What constitutes a reasonable price?
QARP, therefore, is not about value or growth per se. It is more an overarching focus on quality businesses in strong market positions that are able to control more of the range of activities involved in making a good or service, or “value chain” over time.
Equally, we aim to avoid business models that are at risk of disintermediation. This is occurring as the internet is increasingly allowing the manufacturers of products or providers of services to communicate directly with end clients. This can result in companies ceding position in the value chain to competition, suppliers or even customers.
We believe that the distinction between value and growth is somewhat arbitrary owing to the fact that growth is a key factor in the calculation of value. Furthermore, growth only adds economic value if the company earns a return on investment that is above the cost of capital.
So what constitutes a reasonable price? To our mind, there is no single answer to this question. In general, we will have far greater focus on cash flow valuation metrics as opposed to earnings-based measures due to the latter’s ability to be manipulated and portray a distorted picture of reality.
However, ultimately we judge every investment on its own individual merits, assessing the valuation in the context of its own history and relative to the industry in which it operates. Such a valuation overlay will eschew the most expensive “glamour” segments of the market (see: Mind the GAAP! The dangers of “growth at any price” stocks) in favour of high quality businesses that provide more balanced and sustainable returns.
Furthermore, an interesting corollary of the QARP process is to naturally tend towards those businesses with strong sustainability credentials.
The evidence to support QARP investing
The long-term performance of QARP as a style is illustrated by research house Bernstein. QARP has outperformed both the quality style and the MSCI UK benchmark over the long-term (see chart, below).
Since 1990, QARP has generated an annualised return that is c.3% and more than 7% ahead of Bernstein’s index of quality stocks (see notes at foot of the chart) and the MSCI UK respectively. It is clear that having a valuation overlay has served to augment the return profile of quality investing.
We believe it’s important that investors don’t limit themselves to following somewhat arbitrary style distinctions. As we saw in 2020, the QARP approach is a flexible alternative which allows stock pickers to take advantage of market dislocations.
Value - A style of investing which focuses on stocks that appear to trade at a lower price relative to their fundamentals, such as dividends or earnings.
Growth – A style of investing which focuses on stocks whose revenues and earnings are expected to increase at a faster rate than the average company.
Earnings per share (EPS) - An indication of a company’s profitability relative to each ordinary share, reached by dividing the company’s net income by the number of ordinary shares in issue.
Return on Capital Employed (RoCE) – An indication of a company’s profitability relative to all its sources of capital, including the ordinary share capital, retained profits and debt.
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